Yee Ltd is a decentralized company with four divisions. The divisions are evalua
ID: 2423694 • Letter: Y
Question
Yee Ltd is a decentralized company with four divisions. The divisions are evaluated on ROI, with bonuses given to divisional managers with the highest ROI figures.
The company’s X Division has operating assets of $5,250,000. Operating results for the Division for 2004 are as follows:
Sales - $21,000,000
Less:Variable cost - $13,400,000
Contribution Margin - $7,600,000
Less: Fixed Expenses - $5,920,000
Net Profit - $1,680,000
Operating Assets - $5,250,000
Yee Ltd had an overall ROI of 18% for 2004. X Division has an opportunity to add a new product line that would require an investment of $3,000,000. Details relating to the new investment are as follows:
Sales - $9,000,000
Variable expenses - 65% of sales
Fixed expenses - $2,520,000
Required:
a) Compute X Division’s ROI for 2004. What would its ROI be if the new product line is added? Without doing any computations, would the manager of X Division be willing to add the new product line?
b) Why do you think that the company is anxious for X Division to add the new product line?
c) Suppose the company decides to evaluate its divisional managers based on EVA. The company’s minimum required rate of return is 15%. The tax rate is 20%. Compute the EVA of the new product line. Would the manager of X Division be willing to add the new product line?
d) The manager of X Division is considering the disposal of obsolete inventory and reduction of advertising and repairs to machinery. Comment on the effectiveness of these actions on net income of X Division.
Explanation / Answer
A.
ROI = net Income/investment
=$ 1680000/$5250000
= 32%
ROI after new product line added,
New product line net Income = $9000000 - $2520000 - (65%*9000000)
=$ 630000
New ROI = (1680000+630000)/(5250000+3000000)
= 28%
As the proformance is judged on the basis of ROI the manager will not want to add the new product line . it reduce the ROI so his performance will be also judged less.
B ..
Reason to be anxious to add the new product Line by company,
Company would be diversified if new product line is added. Chance of growth in new product line can also make the company grow in future. 21% ROI is also a good ROI for a new product to be added. It increase the future opportunities for growth.
C.
EVA =( net operation profit after tax - cost of capital)/cost of investment
EVA( before adding new product Line) =[{ 1680000(1-.20)} - (15%*5250000)]/5250000
= 10.6%
EVA ( new product line) = [{630000(1-.20)} -(15%*3000000)]/3000000
= 18%
Based on Eva the manager want to add the new product line as it gives the increased Eva of 18% than before Eva of 10.6%
D. As the cost of good sold decreases due to these decisions. It will have favour effect on net income, Eva and ROI.
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